In the early years after the credit crunch the European mid-market was a much narrower concept, without the many highways and byways of today. Borrowers were predominantly sponsored companies, and they usually came to London, where the debt funds were based. Deals were usually in several tens or perhaps the low hundreds of millions of euros.

To put it another way, most mid-market direct lenders were on the same road, making similarly sized loans to companies with similar backgrounds. But this road has forked, and each fork has divided two or three times, as mid-market lenders have responded to changed circumstances. Sticking to the busiest thoroughfare may not deliver enough returns for low enough risk, so there are now many sub-markets within the broader concept of the mid-market in Europe.

This is summed up by Andrew McCullagh, managing director at Hayfin Capital Management in London. “The last four or five years have seen a conspicuous proliferation in the number of managers running direct lending strategies in Europe,” he says.

“Logically, because these new entrants don’t have the track record to raise large funds and want to dip a toe into the asset class, they set up in London with a relatively small team and a focus on the most easily addressable area of the market, namely vanilla senior-secured debt for mid-cap buyouts being marketed by London’s developed network of intermediaries. Consequently, competition for this type of deal has been very high now for a few years.”

One road taken by mid-market lenders has at times taken them out of the mid-market altogether. As direct lending has grown in popularity among investors, funds have become larger, resulting in direct lenders having to look for larger deals.

The mathematics of this is explained by Eric Gallerne, partner in charge of private debt at Idinvest, the Paris-headquartered alternative asset manager: “Last year some managers raised huge amounts.”

The UK’s BlueBay Asset Management, for instance, announced in February that it had raised more than €6 billion. Gallerne says that for managers with funds of this size, deals in the €50 million-€70 million bracket – which Idinvest typically targets – are too low. If a deal size averages €60 million, the manager would have to do 100 transactions during the typical three-year period of investment. This is far above the 30 or so deals that fund managers like to limit themselves to and requires an unfeasibly large amount of deals with the danger of sub-par risk monitoring.

Syndicated territory

Eric Capp, partner and head of origination for the UK and Ireland at Pemberton, the London-based mid-market direct lender, puts the border between the syndicated market and the mid-market – where direct lenders are more likely to compete against each other than against the banks – at about €200 million-€300 million. Above this level, where banks make syndicated loans, the characteristics of deals are different. “When there is a syndicated market alternative, that is when we see the most pressure on pricing, terms and conditions,” he says.

He recites a list of covenants including restricted payments, debt incurrence “freebie baskets”, EBITDA add-backs used to calculate adjusted EBITDA, and several financial maintenance covenants. In the syndicated loan market there are often no maintenance covenants at all. Pemberton generally avoids this sector, while Hayfin approaches it only very selectively through its direct lending strategy.

“As deals get bigger, private debt funds begin to compete with the syndicated market while still needing to deliver a premium to their investors over syndicated loan funds,” says McCullagh. “It’s therefore not clear that competing head-on with the syndicated market always makes sense.”

“It’s not clear that competing head-on with the syndicated market always makes sense”

Andrew McCullagh

Capp notes that, by contrast, when deals fall to €150 million or so, “there really is no syndicated alternative, so the market is still pretty tight, with more conservative structures”.

However, this area, often defined as the upper mid-market, can be crowded too. Capp says that in this market some deals terms are “a little looser than a year or two ago”, though this depends on the situation. Proprietary transactions have less pressure on terms, though he adds that even for more competitive transactions direct lenders are generally able to demand between one and three maintenance tests.

Many debt funds have increasingly turned to larger upper mid-market deals, as they raise more funds that have to be deployed. However, Idinvest has stuck with deals in the mid-to-high tens of millions of euros of EBITDA, in what is often defined as the core mid-market. These are compatible with the size of its funds, says Gallerne – the firm is just finishing investing its €715 million fund Idinvest Debt IV, and hopes to raise €1 billion for its next one. “In our market, we have fewer and fewer competitors: fewer than five of my peers, plus the local banks,” he says.

Holy Grail

Another fork in the road has been the non-sponsored market. This is large in the US, suggesting room for further development in Europe. An attraction is the relative lack of competition. Moreover, sponsored lenders do not generally have debt advisors who are experts at getting the best terms possible for borrowers.

“Non-sponsored work is the holy grail for debt advisors,” says one market observer. This is an appropriate term: non-sponsored work is not only desirable, given the size of the potential market; it is also extremely elusive.

“If a debt advisor forms a relationship with a sponsor, they might do three or four deals a year for them,” he says. “If they form a relationship with a non-sponsored firm, they might do one deal every five years.”

“Niche strategies have grown in size along with the private debt market
in general”

David Waxman

But despite the less competitive nature of lending to non-sponsored firms, which have a skilled debt advisor playing one aspiring lender off against the other, Gallerne is lukewarm about non-sponsored deals.

“Financing a private equity-backed SME means financing a very well-organised company with clear performance, and clear procedures to provide you with regular financial information. This is key because we don’t operate the company, so we need to be well-informed on a regular basis with regard to key performance indicators,” he says. “For non-sponsored companies it’s very rare that you can find the same kind of information governance.”

McCullagh has a more positive attitude towards non-sponsored deals, though still somewhat ambivalent.

“Increasing your share of sponsorless financings has been a long-term preoccupation of the industry, but naturally there’s a trade-off involved in lending to companies without institutional backing,” he says. “Private equity firms typically run more aggressive processes when raising debt, normally resulting in less lender-friendly financing packages, but they also tend to institute high-quality corporate governance and provide the kind of detailed data that lenders need.

“Sponsorless accounts for about two-fifths of the deals in our private credit strategies, compared to an industry average of around one-fifth, but ultimately that’s a by-product of our more diverse sourcing model, rather than a deliberate choice to favour non-sponsor-backed companies.”

This diversity in sourcing to which McCullagh refers is increasingly achieved by taking another fork in the road – expanding beyond London. After setting up shop in the UK capital in 2009, Hayfin opened origination offices in Paris, Frankfurt and Madrid, putting boots on the ground in less crowded markets. It also has an origination office in New York. From its base in Paris, Idinvest has expanded to open investment offices in Frankfurt and Madrid.

The radiating out of offices from an original single base has been assisted by the general move towards more creditor-friendly regimes, though it is still the case that few regimes are as creditor-friendly as the UK’s.

There is a limit to how far east most of this radiation extends. “We depend on enforcement and insolvency regimes for downside protection if the deal goes wrong,” says Capp. “As you move further east of Germany, those regimes are more immature, and this introduces an additional element of risk.”

But when asked if across Europe in general, jurisdictions are becoming more creditor-friendly, he replies “for sure”, giving Spain and Italy as examples.

However, there is one road not yet taken by many lenders: cultivating specialisms in niche areas where lack of expert knowledge means less competition. McCullagh says Hayfin has developed expertise in specialist sectors such as healthcare, shipping and oil and gas – areas where he feels that the majority of lenders lack the knowledge to underwrite loans prudently.

David Parker, partner at Marlborough Partners, the debt advisor, in London, sees the argument for niche players: “If you’re going to enter the market now, there has to be a reason: there needs to be a niche rather than a broad market opportunity, because inevitably if there’s a broad market opportunity people are already feeding off it.”

Niche players may have agreed with this argument in theory, but practice has been different, Parker points out. “We expected US lenders to come over and play niches because the middle market was crowded, but they haven’t really” – with few home-grown players going down the specialist route either. Specialism is the road that remains less travelled.

American specialists
A more mature US market is witnessing growth in niche mid-market lenders keen to differentiate themselves from the competition

The infinite variety of niche lenders in the US contrasts with the reluctance to consider niches in Europe. On the western side of the Atlantic are funds specialising in trade finance, art finance, lending to growing tech businesses and aviation finance. The last of these has grown rapidly in recent years as low jet fuel prices have encouraged new entrants and encouraged existing players to beef up their fleets, says David Waxman of Azla Advisors based in New York.

It is not only aviation finance that is on the rise. “Niche strategies have grown in size along with the private debt market in general,” says Waxman. This has propelled them towards a tipping point: they are now large enough for large institutional investors to invest in them.

A commitment to 10 or 20 percent or so of the fund’s total planned capital – the sort of level above which institutional investors are forbidden to rise – is more likely these days to make it above the minimum threshold of some tens of millions of dollars required for any single fund investment. In a sign that niche strategies are entering the big time, Carlyle, the mammoth alternative asset manager, announced in October 2018 the acquisition of Apollo Aviation Group, which had $5.6 billion under management, including aircraft leased to customers.

Waxman also thinks the risk-adjusted returns of niche strategies are likely in many cases to have held up well, because the small number of competitors allows them to impose strict terms on borrowers.

John Finnerty, senior managing director in corporate finance at NXT Capital, a mid-market lender to sponsored firms based in Chicago, has noticed that generalists have grown bigger too. “A major development over the last two or three years is the proliferation in the number of players that can now hold deals worth $100 million, and in some cases even $200 million and above,” he says. “In our markets this has risen to the late teens. This has changed the competitive dynamic.”